The Series A Crunch is a supply-demand imbalance that will result in over 1000 seeded startups being orphaned and more than $1 billion of investment evaporating. It is all part of a healthy natural selection process.

Where is this data coming from?

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Where is this data coming from?

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Our Seed Investing Report analyzes 4056 seed investments made into US-based technology companies since Q1 2009. For clarification, seed investments are early stage investment (typically less than $1.5 million) made by either angel investors (those investing their own money) or venture capitalists (those investing others money).

Below are some of the highlights/findings of our analysis.

The “Series A Crunch” is Just Math

Despite the concerns about a crunch, the reality is that the level of Series A activity is holding steady. At the same time, the number of seed deals have exploded. As a result, the Series A Crunch is nothing more than excessive demand for a limited supply of Series A financings.

The “natural selection” this forces will be a net positive (see below) but will mean that many startups will be orphaned and that some investors will lose their money.

1000+ Startups Will be Orphaned; $1 Billion+ Lost

The process of natural selection that will happen with seed companies (and which we’d argue should happen) will result in over 1000 recently funded seed companies being orphaned, i.e. unable to raise follow-on financing.

This will result in over $1 billion of investment into these companies being incinerated, but again, this is nothing new. Seed investments are the riskiest bets an investor can make and the reality is most will not return money. Again, the death of startups and the loss of investment dollars is part of the process of separating the best companies and investors from those which aren’t.

The eventual death of many of these companies may also help the tight labor market for other startups who are looking for capable and driven talent.

Seeded Cos Need 13+ Months to Raise Next Round

Across quarterly investment vintages, we see that it takes Seeded companies slightly more than 13 months to raise financing on average. The speed with which follow-on financing is raised has seemingly accelerated over time.

As the leverage increasingly looks like it is shifting towards investors, it would seem that the amount of time it will take to raise follow-on financing will increase over time for recent and future vintages.

Almost 4 of 10 Seeded Cos Get Follow-On Financing

On average, 39.4% of seeded companies go onto raise follow-on financing. Interestingly and contrary to what the punditry have often said, seed deals in which VCs participate have a historically higher rate of getting follow-on financing as compared to seed deals in which VCs are not participating.

Internet Sector is Tops for Seed Deals

Not surprisingly, the internet sector is the primary destination for seed investing. Interestingly, follow-on financing rates to the computer hardware & services sector is the highest of all tech sectors.

Cali and NY Dominate for # of Seed Deals

California is the clear #1 for seed investment activity followed by strong #2 New York. Massachusetts is a distant #3 but in terms of the rate of follow-on financing, Mass has the highest rate.

The New York seed boom which has buoyed the state’s investment activity #s for some time probably also means that NY will see the highest proportion of orphaned startups. This could also spell opportunity for those in the acqu-hire game or for companies looking to recruit talent away from these companies.

Thanks for taking the time to quantify this phenomenon. It feels like we also need to take time to qualify beyond just “survival of the fittest”. That is to say that there is certainly good to come from broader seeding activity. It certainly encourages entrepreneurship, hopefully innovation and possibly even a higher quality of ultimately funded deals. It’s too early to tell if the $1bn+ lost will be made up for in the ultimate value of companies built and jobs created in this broader seeding paradigm.

One question lingers for me. Is there a more efficient way to do this? Could we for example invest more in the watering of the seeds. That is to say by investing time not capital into these earlier stage companies in the form of mentorship and coaching. That has been the most needed early stage investment in my experience.

And just as buying your kids presents when you return home doesn’t make up for the time not spent with them when you were away, so I fear we are raising seed investments that will just think that money is all they need to go the next step in their journey. And so even if they raise a series A, is that really a measure of success? And what’s next? Multiple billions lost in the Series B crunch?

I fear we will have entrepreneurs in rehab unless we step back and develop three things. First the right set of expectations upfront as to what it takes to really build a company – beyond money. Second the training and development programs that don’t just “accelerate” companies, but solidify their propositions. And finally we need to re-balance the mentorship and coaching of the next generation of entrepreneurs to enable them to leave the nest with confidence to build on the proof of their market validation not just on the valuation afforded by VCs.

To be clear this is not a criticism of the great work that is being done by many terrific programs like TechStars or Y Combinator and many others. Indeed there are many people who I admire who are devoting themselves to these issues and from whom I’m learning to engage myself. (My own very small contribution at Harvard can be found here http://mjskok.com/resources/introduction). So thank you for raising the discussion with data to fuel our thinking.

I couldn’t agree more with Michael. The truth is that the VC industry has outsourced the most experimental part of the process to the new band of angels and they are about to find out what its like to be caught on the other side of the park. 2013 will be a great time for the best entrepreneurs and early stage VCs to turn the best performing concepts into billion dollar businesses.

The bulk of them increased their investment pace because in the past few years many of their projects got follow on financing…lets see how they behave when the number of projects that gets through Series A drops dramatically. The angel business is a cyclical business.

The bulk of them increased their investment pace because in the past few years many of their projects got follow on financing…lets see how they behave when the number of projects that gets through Series A drops dramatically. The angel business is a cyclical business.

Sure and same goes for VC. In market disruptions (VC rationalized, super angels and so forth) behaviors tend to get irrational, no question. I was reacting to the fact that (no denying the cycles) most angels I have worked with know well what they were doing and have enough experience under their belt to understand the risks and cycles. I also prefer to work collaboratively with the angel community rather than default back to a “us versus them mentality” … which I am in no way suggesting you have but I did hear one senior local VC saying he liked to screw angels for sport and one senior angel club guy effectively saying VC’s were systemically out to abuse entrepreneurs and angels. This is the exception not the rule but this kind of zeitgeist is not helpful to anyone.

I totally agree! My point is that assuming you know how to pick ’em next year will be a great time to invest in Series A deals. Capital intensity or not there is a systemic mismatch in capacity. Valuations and terms are already starting to get more balanced and there are more things to look at. The top ideas and teams will still get financing on premium terms. This is similar to the environment we had in 1993/94. On your point about angels knowing what they are doing I think there is a full distribution: there are top notch folks that do this for a living like Keith Rabois and Bill Warner who are awesome. Conversely there are also doctors, facebook engineers, real estate folks who’ve started to invest in random deals but have little experience angel investing. For some reason I see less of the latter crowd in Boston. Those are the folks I think will come and go with the ups and downs.

I think this is great data but not sure the analysis is complete without understanding the shift in deal size (larger seeds / series seed) and smaller series A that become indistinguishable … The hybrid A if you like. So past may not be accurate predictor. Also curious to see whether initiatives like the AngelList crowdfunding initiatives become game changers.

CB Insights

Fred,

Thanks for the comment. While these are interesting data points, they either (1) don’t impact the numbers or analysis in any material way or (2) the actual data doesn’t prove them out. Yes, there are “seed” deals of $5 million, but those are not all that common and the seed designation is more marketing in those cases (“we closed a monster Seed round vs. a sort of average Series A round”).

The smaller Series A’s also is not borne out by the actual data. Sure there is an odd one here or there, but there has been no observable decrease in the size of Series A fundings in aggregate over time to the tech sector.

Even if the data did bear out this hybrid Series A round (it doesn’t), the underlying story remains unchanged — heightened demand for follow-on financings and a relatively fixed supply creates a chokepoint for companies. As for AngelList and other crowdfunding initiatives, it would seem that they’d exacerbate the problem of “orphaned startups” ultimately as they’ll create more early stage companies. While the “it’s cheaper to build a tech company” holds at the very early stages, the reality is that to get big (venture-level), they’ll all require money to scale.

The more interesting story in our view is whether all this Series A Crunch angst is actually a great thing for VCs. More companies who get to prove their mettle with less money giving VCs better companies to invest in later on. It (the crunch) may be painful for entrepreneurs who can’t get follow-on funding but for VCs, it should mean picking from a better crop of candidates. So VCs who can identify the best seeded companies in a methodical way should do better by virtue of fishing in a better pond.

The other interesting potential point is whether this crunch forces entrepreneurs to re-align their method of growing their business, i.e., focusing on short-term profitability/cash flow positivity so they’re not subject to financing whims/cycles, investor leverage, etc. For many orphaned startups, that will be the only way to carry on but may mean the creation of the derided “lifestyle businesses”.

If I understand the classification correctly, a seed deal is any financing under $1.5M. My question is specifically whether you are looking at any financing event being a “seed deal” or whether you are looking at a specific startup being the entity.

In other words:
– Are we looking at number of seed financing events or number of companies backed ?
– When a company raises a first round of $800K and a second round of $1M (for example) are we counting two seed deals ?

In any event i would be interested in looking at the number of companies backed and any trending data you have on seed funding size and series A funding size as this is very interesting to the industry.

I think big fat pendulum swings that destroy confidence are never good for the industry.

Yes, I agree. There is more companies at poorer quality probably. Not the ratio might not differ that much, and there are more of high quality as well (than before). But there is also another factor at play, the increased cost efficiency of building technology startups has two major impacts:

– You can build a profitable business that do not need to be a billion dollar business, addressing a more nisched market. These businesses do not need A-rounds typically.
– You can build a scalable business for seed-level funding in many cases. If you capital need is less than $1.5M for creating a profitable and scalable business, you do not need an A-round.

Startups that fall into these two categories, especially the latter, might raise series A funding, but some wait much longer because they start to grow from their positive cash flow.

Disclaimer, this is based on what I see in our portfolio, and in companies in the Silicon Valley eco-system.

mjskok

Good points Nicolai. And you’re right if they intend to build smaller businesses, seed may really be just a synonym for small series A.

However too many companies think of capital efficiency as being based solely on what it takes to build product. In reality as you know the real expense is in Go To Market. Again I agree though that if they figure out how to crack that from a seed and get Cash Flow positive that’s truly impressive and very unusual.

We’ve definitely seen our overall capital intensity go down. It was $15M two funds ago, $12M last fund and looking currently like $8-10M in our latest fund.

lennygrover

How are you measuring capital intensity? The reopening of the IPO window is allowing companies to go public earlier than the recent past and M&A activity has picked up since the downturn.

Are you seeing companies get to $X in revenue and $Y in EBITDA with less capital, or merely to an exit of comparable size? An open IPO window, coupled with cheap debt and inflated stock prices for the usual strategic acquirers, makes the latter more likely.

The current trend favors early stage VCs, but I suspect there will be a lot of unhappy angels (from Series A cramdowns as well as failures).

CB Insights

Cheyenne,

Thanks for the comment. To clarify, we’re making no such assumption, i.e., that seed companies are of similar quality. We merely wanted to put some data behind the conversation about a Seed – Series A Crunch.

That said, you’re def right that some cr^ppy things have been funded, but that is the nature of the early stage investment game all of the time.

You have really no way separate the wheat from the chaff. The market is changing dramatically (lower K intensity, crowdfunding, superangels, angellist and so on) and so it certainly leads to overheating. But let’s not ignore structural changes either by assuming lower quality is the only explanation. The funding world has changed and the shape of startups too.